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The bulls have it all wrong, at least in the short run. So opines Jason DeSena Trennert, managing partner of Strategas Research Partners in New York. Forget about accelerating earnings. Corporate profit estimates for next year are too high, he says, and companies need more top-line growth. Throw in the weak economic expansion and the so-called fiscal cliff—shorthand for a combination of federal spending cuts and tax increases set for the start of 2013—and, Trennert warns, a recession next year is likely.

A silver lining in his otherwise downbeat prognostication is that he expects any recession to be a mild. With bond yields compressed and likely to stay that way for some time, Trennert maintains that large-cap, dividend-paying stocks are the best option for investors.

"Equities may be your only chance of receiving real returns...for a long period." -- Jason DeSena Trennert
Gary Spector for Barron's

Before helping found Strategas Research Partners in 2006, Trennert had worked for many years at International Strategy & Investment Group (ISI), a boutique firm that does research for institutional investors. Trennert, who turned largely bearish on equities last year, around the time of the federal budget impasse, forms his views with the aid of his partners: Don Rissmiller, his firm's chief economist; Nick Bohnsack, its sector strategist; and Dan Clifton, who handles its Washington research. Trennert, 44, spoke with Barron's last week in his midtown office.

Barron's: When you sat down with us in 2009, during the financial crisis, you were worried about inflation, and recommended gold. What's your view now?

Trennert:The thought at that point was that it would be hard for the Fed to quadruple the size of its balance sheet and also to stick the landing on inflation. I still think inflation is a long-term concern, mainly because other central banks have joined the act, particularly the ECB [European Central Bank] under President [Mario] Draghi.

How did your call on gold and inflation turn out?

I think it's correct, long-term. But the seriousness of the deflation we were facing back then was larger than we had anticipated, and the excess capacity, particularly in housing, was far more than we had anticipated. We used an expression up until last year: "We're bullish until the bill comes due," and the bill took a little bit longer to arrive than we had anticipated.

Where does gold fit into your portfolio these days?

Until central banks stop printing money, it's hard to see gold prices going down materially. So the real risk to gold is structural reform of our fiscal situation, which is very possible, but until I see a real desire for fiscal reform in the developed world–and the central banks continue to provide liquidity–I think gold is going to move higher.

Turning to 2012 and beyond, what's your macro view?

While there are very good reasons to be very bullish on equities longer-term, particularly versus bonds and real estate, we are worried about 2013 for two reasons. No. 1 is that we think earnings estimates are much too high and that they are facing a series of downward revisions. Second, we are also facing the fiscal cliff. Now the fiscal cliff may not be as significant as some have suggested, but avoiding some fiscal drag next year in an already weak economy is going to be very difficult.

What are people missing in their analysis of the fiscal cliff?

Most of our clients view the fiscal cliff as a binary event, which is to say that it will either be completely solved, in which case there will virtually be no fiscal drag in 2013, or it will completely fall apart, in which case you will see the full brunt of a $540 billion drag on gross domestic product next year. Most believe that there will be some death-bed conversion in Congress, and that the problem will be fixed. But it is not that easy, because there are elements of the fiscal cliff, mainly the payroll-tax cut, the extension of unemployment-insurance benefits, and the Obamacare taxes, that will be hard to avoid. At a minimum, you'll have a [fiscal] drag of $120 billion on the economy next year.

So, effectively, there will be a tax increase?

The reason that's important is that in real GDP terms, the economy is growing at just 1.5% or 2%. If you subtract 75 or 80 basis points [0.75-0.80 of a percentage point] from GDP, that's meaningful. There is not a lot of margin for error.

Could you elaborate on your earnings forecast for next year?

We are using $93.50 for S&P operating earnings, which is lower than the about $100 you'll have this year. In an average recession, earnings fall about 20%. We think this recession will be milder. We are calling for a recession, mainly because nominal GDP growth is so low globally, and you are going to get the fiscal drag. We are not calling for a decline in earnings to the same extent that you saw during the last two recessions, mainly because, at the very least, the earnings foundation from a sector level is much broader. So in the past two recessions, the S&P was very dependent on the earnings of one sector in particular. In 1999 and 2000 it was technology, and in 2007 it was the financials. This time, that kind of a scenario is very unlikely.

But you do see a recession coming?

We do. Profit margins are two standard deviations above the mean, and nominal GDP growth of 3.1% in this year's first half was at a level normally associated with a recession. But sell-side analysts right now are calling for an acceleration of the growth rate of earnings in the fourth year of the business cycle, when the profit margins are already two standard deviations above the mean. We're saying that you need top-line growth, and there are limits to how much companies can cost-cut their way to profitability. Eventually, you need actual growth in nominal GDP to sustain the economy. So I'm not happy to say this, but there is a not an insignificant chance that you have a mild recession in 2013, and it is very difficult to have a mild recession without a meaningful decline in earnings.

You've mentioned margin pressures; what else do you see pressuring corporate profits next year?

China is slowing, Europe is in recession, and the U.S. doesn't seem to have any meaningful plan for an acceleration in growth.

What's your take on the presidential election?

About 60% to 70% of our clients are Republicans, and so most of them would like to see Mitt Romney win. But when we ask them—and we do this systematically—who they think will win, 60% to 70% say President Obama. If Romney were to win, I do think, at least in the short term, it would be a positive surprise for institutional investors. I would view that positively, and that's all for the main reasons, including somewhat lower corporate taxes and more clarity about the regulatory environment. But to be fair, both parties are going to have to eventually deal with the unsustainable federal spending.

And so over the next year, year and a half, I'm not sure it would make all that much difference, because both parties are going to have to take some tough fiscal medicine. And I wonder, when the reality of facing some sort of fiscal austerity hits, how well the market will see through that. I'm very bullish longer-term, if we can actually embrace fiscal reform, but I can also see how the market may not like it so much when it is actually presented with the reality of what fiscal austerity will do to GDP growth.

You've been cautious about the stock market, so has the recent run-up been frustrating for you?

I've been somewhat surprised at how resilient the market has been, but by the same token a lot of the things that we've been pitching–including high-quality, large-cap stocks—have been outperforming.

Trennert's Picks

Recent

Company

Ticker

Price

Merck

MRK

$44.66

McDonald's

MCD

91.57

IBM

IBM

206.36

Oracle

ORCL

32.62

Source: Bloomberg

We've not participated in the rally as much as we would have liked, but the general sentiment has worked out. Eventually, there will be a cost to this amount of central-bank manipulation, for lack of a better word, in the overall economy. Sooner or later, a price will be paid.

What about asset allocation now?

In New York, probably the worst thing you can say about someone is that they are consensus. There is a general sense that the dividend trade is over-owned and that it is hopelessly consensus. But it is hard to make a case for that argument, because there are still net redemptions from income-oriented equity mutual funds. You look at fiduciaries and their asset allocations—the pension plans and the endowments, for example–and they've continued to use long equities as a source of funds for other investments, particularly alternative investments. From a longer-term perspective, the good news is that a very good case can be made that virtually all types of investors, maybe with the exception of foreign investors, are underweight U.S. large-cap equities. It's very likely that our government will pay negative real interest rates on its debt for the foreseeable future. So stocks may be your only chance of receiving real returns, or returns in excess of inflation, and dealing with financial repression, for a long period. But there will be volatility, given the macro head winds.

What do you mean by financial repression?

It is a modern form of devaluation. Instead of just printing more currency, the sovereign, or the country, pays interest rates below the rate of inflation, and you're hoping that inflation chips away at the principal over time. One could say that the Fed's Operation Twist is a form of financial repression, because it artificially keeps long-term interest rates lower than inflation. People buy riskier assets, and the government's funding costs are lowered.

What's to like about Merck, McDonald's, IBM, and Oracle, whose stocks you favor?

Investors need yield, but are afraid to take too many risks to get it, so there is a chance that a new Nifty Fifty gets created, consisting of large-cap companies with fortress-like balance sheets—and that also provide dividend yields. Last year, when the U.S. government's debt was downgraded, we counted 55 companies that had credit-default swap spreads lower than those of Uncle Sam. So there are 55 companies that the market believes are better credit risks than Uncle Sam, and we put all of these into a basket called the new sovereigns. We're saying increasingly that investors will gravitate toward these equities as a proxy for sovereign bonds. So not only do these companies have strong balance sheets, but certainly in the case of
IBMibm 0.35673681664247703%International Business Machines Corp.U.S.: NYSEUSD165.9499
0.58990.35673681664247703%
/Date(1481302414889-0600)/
Volume (Delayed 15m)
:
808621
P/E Ratio
13.503781457817187Market Cap
157233380150.668
Dividend Yield
3.379666957961771% Rev. per Employee
212324More quote details and news »ibminYour ValueYour ChangeShort position
[IBM] or
Oracleorcl 0.7311028500619579%Oracle Corp.U.S.: NYSEUSD40.645
0.2950.7311028500619579%
/Date(1481302407229-0600)/
Volume (Delayed 15m)
:
2586685
P/E Ratio
19.41104761904762Market Cap
165662770273.369
Dividend Yield
1.4719158456647172% Rev. per Employee
273485More quote details and news »orclinYour ValueYour ChangeShort position
[ORCL], they have dividend-payout ratios that are low enough so that they can greatly increase.

Oracle doesn't have a big yield.

No, it doesn't. But one of the questions we get asked a lot is: Is the dividend trade over? We continue to harp on the fact that the dividend payout ratio of the S&P 500 is 29%, well below historical norms of about 50%.
Cisco Systemscsco -0.0667779632721202%Cisco Systems Inc.U.S.: NasdaqUSD29.93
-0.02-0.0667779632721202%
/Date(1481302415639-0600)/
Volume (Delayed 15m)
:
6831548
P/E Ratio
14.241238095238096Market Cap
150341779562.194
Dividend Yield
3.4774932623568042% Rev. per Employee
663731More quote details and news »cscoinYour ValueYour ChangeShort position
' [CSCO] decision to increase its dividend greatly last month may be seen as a watershed event. That's because a lot of tech companies understand that this is something that can, in the absence of, let's say, killer applications or killer programs, stabilize their stock price. And it is another way of adding value to shareholders. Tech companies have been very slow to understand that, but they are seeing that it can be very helpful. Cisco had one of the best-performing stocks in the S&P 500 in August, after it increased its dividend. And
Appleaapl 1.7659650374598643%Apple Inc.U.S.: NasdaqUSD114.1
1.981.7659650374598643%
/Date(1481302415975-0600)/
Volume (Delayed 15m)
:
11002248
P/E Ratio
13.815598548972188Market Cap
597858946891.729
Dividend Yield
1.9955363003807274% Rev. per Employee
1846780More quote details and news »aaplinYour ValueYour ChangeShort position
[AAPL], in terms of dollars paid, is the third-largest provider of dividends, even though its yield is lower.

What's appealing about Oracle?

Oracle has the potential to increase its dividend greatly and add value that way.
Merckmrk 1.8629407850964737%Merck & Co. Inc.U.S.: NYSEUSD61.24
1.121.8629407850964737%
/Date(1481302406558-0600)/
Volume (Delayed 15m)
:
2167196
P/E Ratio
31.20408163265306Market Cap
165759129974.981
Dividend Yield
3.0739045127534337% Rev. per Employee
583162More quote details and news »mrkinYour ValueYour ChangeShort position
[MRK] has a dividend payout dividend ratio of 74%,
McDonald'smcd -0.08302200083022%McDonald's Corp.U.S.: NYSEUSD120.35
-0.1-0.08302200083022%
/Date(1481302411243-0600)/
Volume (Delayed 15m)
:
350229
P/E Ratio
22.754253308128543Market Cap
100026973619.251
Dividend Yield
3.123701919082828% Rev. per Employee
59367.4More quote details and news »mcdinYour ValueYour ChangeShort position
[MCD] is 50%, but IBM's is only 22%, and Oracle's is only 12%. The average payout ratio throughout time has been close to 50%, so IBM and Oracle are two simple examples of companies with great potential to increase their dividends without harming their long-term growth prospects.

You've been critical of the way liability-driven investment is being handled. But if a pension fund needs, say, $250 million in 20 years, and it invests based on meeting that goal, what's the problem?

You are trying to pair your assets and your liabilities, which seems to make eminent sense. But investors are doing that through very low allocations to equities and very high allocations to alternative investments and maybe, to a lesser extent, to fixed-income investments. It may satisfy an emotional need to feel safe, but it potentially leaves an enormous amount of investment performance on the table, especially after the S&P really hasn't made a new high in 12 or 13 years. It is still trading at 14 times 2012 earnings. It is not uncommon to see pension funds or endowment funds with allocations of 50% in alternative investments. That will limit these investors' long-term returns.